This Is Way More Important Than Earnings

The concept of "earnings" is an accounting fiction. Oh sure, for the most part and over the long run, what companies report as their earnings comes close to representing how well they performed. But on a single quarter's or single year's basis, what gets reported as earnings may be nowhere near an accurate depiction of what actually happened.

Companies have lots of levers they can pull to temporarily report stellar earnings even when their operations are weak. Take, for instance, the "no payments, no interest for one year" deals often offered by appliance and furniture retailers. As soon as you sign the paperwork and take the item home, the store books the sale and the accounting profit. The actual cash from that transaction, however, doesn't show up until you pay the bill.

Cash flow is still king
Therein lies the problem with relying on reported earnings alone to determine a company's operational strength. The store in that example likely had to pay the manufacturer actual cash within a month or so of receiving the product, but won't see a dime from you for quite some time. Even worse for the retailer, by reporting the profit, it needs to pay taxes (also from actual cash) well before the money from that sale actually arrives.

That's an incredible disconnect between cash flow and earnings. Cold, hard cash is pouring out the door, but upon a cursory glance, the company may look extremely profitable. If all goes well, the company will make up the shortfall as the merchandise gets paid off. If it doesn't, however, all the "profits" in the world won't let it pay its own bills.

What really matters to the company and its investors is its ability to convert sales and earnings into cash. When you uncover a business that does an exceptionally good job of that, it's generally one worth owning.

Who's doing well?
Fortunately, it's not hard to find businesses that do a great job of generating cash. The ones in the table below have all reported free cash flows (defined as cash from operations minus capital expenditures) in excess of their accounting profits over the past year:

Company

Free Cash Flow
(in Millions)

Earnings
(in Millions)

Price-to-Earnings Ratio

Price-to-Free Cash Flow Ratio

General Electric (NYSE: GE  )

$23,917

$11,734

14.9

6.8

IBM (NYSE: IBM  )

$17,605

$13,039

13.2

9.2

AT&T (NYSE: T  )

$19,252

$11,920

13.5

7.9

Honeywell (NYSE: HON  )

$3,190

$2,162

13.6

9.0

Reynolds American (NYSE: RAI  )

$1,283

$1,005

14.7

11.0

Heinz (NYSE: HNZ  )

$1,051

$907

15.9

12.3

Quest Diagnostics (NYSE: DGX  )

$811

$717

15.6

13.2

Data from Capital IQ, a division of Standard and Poor's.

As a potential investor, such operational strength helps you in two ways. First, since the companies are actively generating significant amounts of cash, you can be far better assured that their earnings are real, rather than just accounting fiction. Second, thanks to their prodigious production of cash, you're able to buy these cash-generating machines at a better price than a cursory glance at their price-to-earnings ratios would show.

Own the Titans of cash flow
At Motley Fool Inside Value, we happily look past a company's reported earnings and into its true cash-generating abilities. Only then can we tell whether it's really worth owning or if it's a dud, dressed up by clever accounting. It's that relentless focus on cash generation that has helped us stay ahead of the broader market since our 2004 launch.

If you understand the difference between earnings and cold, hard cash, and why cash is the much more important one of the two, then you've got what it takes to join us. If you'd like to see why cash flow counts for so much before joining, click here to start your 30-day free trial. There's no obligation.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Quest Diagnostics is an Inside Value recommendation. H.J. Heinz is a Motley Fool Income Investor pick. The Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 01, 2009, at 5:41 PM, guru111melbourne wrote:

    Can someone explain to me how to arrive at these numbers? I always felt it would be useful, but in looking at the ratios given on the fool, for instance Heinz, there is a different price to free cash flow listed.

    Thank You,

    Sam

  • Report this Comment On December 01, 2009, at 6:12 PM, TMFBigFrog wrote:

    Hi Sam,

    Excellent questions.

    First, please understand that there's no universal definition of Free Cash Flow. For the sake of this article, I used an often accepted estimate that simply takes a company's cash flow from operations and subtracts its capital expenditures.

    I don't know what method for calculating Free Cash Flow the Fool's quote provider uses. If it's a different method than the one I picked, the price to free cash flow ratio will also be different.

    Second, the tables in these articles are static, and the data is based on either the date and time an author wrote it or an editor fact checked it. Whenever the market is open, stock prices change, which cause ratios like price-to-earnings and price-to-cash flow to change as well.

    Third, as companies report earnings, there may be a delay between the press release, the official SEC filing, and the time when the financial data find their ways into research databases and quote feeds. There is always a possibility that one system or another could be out of date and have less-than-current information.

    Finally, it is not unheard of for either an automatic feed or a human being to fat-finger a number or a calculation. If you see what looks like an out-and-out error, please let us know, and we'll be happy to investigate it.

    Best regards,

    -Chuck

  • Report this Comment On December 01, 2009, at 6:53 PM, Eerkes wrote:

    in the first example given, with accounting profits booked before cash is received, it is incorrect to say that the company has to pay taxes on the sale, a company books its income tax expense based on accounting earnings but pays taxes for the most part based on cash revenues and cash expenses

  • Report this Comment On December 01, 2009, at 7:28 PM, jlanganki wrote:

    Hi Eerkes, I disagree with your assessment. The government only cares about "earnings", not cash flow. The example may also be incorrect, just because an item was sold this may not show up as income in the same quarter. Depending on how their accounting is done they may be able to defer the income to when the cash is actually received.

    One thing that often creates a big difference between earnings and cash flow is "capital depreciation". The government is allowing a company to reduce their earnings (and therefore their taxes) by accounting for "wear-and-tear" on equipment they own as an expense. This lowers earnings but has no effect on cash flow.

  • Report this Comment On December 01, 2009, at 8:47 PM, TMFBigFrog wrote:

    Hi jlanganki,

    <i>"The example may also be incorrect, just because an item was sold this may not show up as income in the same quarter"</i>

    That generally happens with things like subscriptions or maintenance contracts, where the service being sold gets consumed over a period of time. When a product is sold outright, revenue is generally recognized when the product is picked up or shipped.

    There might be slight delays in the selling company's ability to recognize revenue, such as if it offers an unconditional money-back guarantee. But the general rule is "when it's shipped, it's sold."

    <i>"One thing that often creates a big difference between earnings and cash flow is "capital depreciation". The government is allowing a company to reduce their earnings (and therefore their taxes) by accounting for "wear-and-tear" on equipment they own as an expense."</i>

    Sort of. In reality, the cash outlay for an item subject to depreciation happened some time in the past, and the government is allowing the company to recognize the cost of that item over its expected useful life. Depreciation helps smooth earnings by allowing companies to recognize capital costs over time, but it doesn't typically allow companies to "double dip" the same cost deductions twice.

    Regards,

    -Chuck

  • Report this Comment On December 02, 2009, at 9:22 AM, JakilaTheHun wrote:

    Great article. I definitely agree that cash flows are more important than earnings.

    However, there is a caveat here --- most companies have lower than average capital expenditures right now due to the current economic environment. Hence, it's still useful to examine earnings very thoroughly.

    HON's free cash flows are much higher than earnings over the past four quarters, but in the past, the two numbers have appeared much closer, with FCF only edging out NI by a much smaller amount.

    Still, it is intriguing to seek out companies with much higher FCFs than earnings because the market could be underestimating its real worth.

  • Report this Comment On December 02, 2009, at 1:01 PM, pondee619 wrote:

    Dear TMFBigFrog:

    "the data is (sic) based "?

    Data plural of "datum"

    the data are based

    the datum is based

  • Report this Comment On December 02, 2009, at 1:05 PM, guru111melbourne wrote:

    Thanks for the response!

    I had another question if anyone wants to impart their knowledge on me :). I keep hearing of IBM's unfunded pension. Is that liabiity not shown in their earnings?

    Also, Jacob's Engineering (JEC) seems to sport a pretty good FCF with a low P/E multiple and Price/Sales, I was thinking of adding it to my portfolio however I would like to get some bashing on it before I proceeded. 8$ cash, no debt, I have a friend who works there and he says they have more work than they can do, and as they are (to my knowledge) pretty much a consulting firm I don't know how their capital expenditures would fluctuate greatly.

  • Report this Comment On December 02, 2009, at 8:14 PM, TMFBigFrog wrote:

    Hi pondee619,

    Thanks for the reminder. :-) My wife, before she became a full-time-Mom, was a research statistician. She, too, made sure I remembered the appropriate use of "data" and "datum". One day, I hope the lesson sticks permanently.

    -Chuck

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